Is the Russell 2000 Fund a Pointless ETF?

Seasoned investors know the reality all too well: While large cap funds and ETFs may be made up of reliable, blue-chip-type stocks, these funds also offer lackluster returns.

If you want to beat the broad market, the only way for buy-and-hold investors to have a shot at doing so is by staking a claim in the small-cap market. Granted, owning small caps means suffering more volatility, but that’s the necessary trade-off for better results.

What happens, however, when that conventional wisdom no longer rings true … when the archetype iShares Russell 2000 Index ETF (NYSE:IWM[1]) doesn’t show any stronger returns than its large-cap counterpart, the SPDR S&P 500 ETF (NYSE:SPY[2])? Is it possible another widely-accepted Wall Street adage has fallen by the wayside?

Or said another way, has IWM become a pointless ETF?

Back Then

Most seasoned investors are already well aware of the fact that, in general, actively-managed large cap funds don’t outperform the benchmark S&P 500 index. In fact, for the past five years, 61% of managed large-cap funds trailed the broad large cap market.

It’s a data nugget that leaves one wondering: If most of the pros can’t even do it, what chance does the retail investor — aka “the little guy” — have of beating the market?

The small-cap market offered a solution. The iShares Russell 2000 Index ETF was unveiled in May of 2000, with several other comparable small cap index-based funds to follow shortly after.

The ETF was a smash hit too, attracting a decent-sized crowd from the onset despite being introduced in a tough market. It then went absolutely ballistic once the market began to hum again in 2003. More importantly, the small-cap index fund outpaced its large-cap counterpart, as history had shown it would. From the March of 2009 trough to the mid-2007 peak, IWM gained 140%, while SPY only advanced 85%.

Times Have Changed

Though small caps may have trounced large caps between 2003 and 2007, the same can’t be said for the period — nor for any segment of the period — between 2008 and 2012. Sure, small caps have technically outperformed since the bottom in March of 2009, with IWM gaining 136% since that low versus the 106% advance from SPY.

But that’s a shrinking disparity, and it’s a disparity that shrinks dramatically when you remove the unusually strong (and so far unrepeated) late-2010 rally from the small-cap segment.

What happened? A couple of possibilities, though there’s no way of explaining either without waxing philosophical.

First and foremost, an investing strategy is only effective if the majority of the trading crowd isn’t using it. In the late 90’s and early 2000’s, small caps were a well-guarded secret reserved for the elite trading crowd and deep-pocketed fund managers who could afford to go deeper into obscure companies. Over the past six years or so, however, small-cap research has become common. Indeed, it’s become a prolific industry in and of itself, negating the edge small-cap investors (institutional or otherwise) used to have.

The second reason small caps have started to post merely-mediocre numbers: Most of them are merely mediocre stocks.

Even when the dot-com era ended up becoming the dot-bomb era, the companies that managed to win funding (via IPO or private equity) were something special with a solid business idea … even if it was a poorly executed one. Investors also expected to see some sort of progress from established small-cap companies, and wouldn’t reward a company by buying a stock that didn’t offer some sort of tangible potential.

Now, however, the IPO-crazed market will throw money at anything and everything, without ever considering the possibility that maybe, just maybe, these companies have nothing to offer relative to the stock’s price.

Groupon (NASDAQ:GRPN[3]) comes to mind. Traders were clamoring for it based on red-hot growth rates and a lot of bullish chatter when it went public in October of 2011. Now, however, the company is regarded as something of a joke (though the stock’s 83% implosion since the IPO is no laughing matter).

And for every high-profile-venture-turned-zombie like Groupon, there are two or three zombie small caps in the ranks of the Russell 2000 or other comparable small cap indices. Investors have simply become a lot more tolerant of them.

Now What?

The good news is that both of those drags on the small-cap indices and small-cap index funds are cyclical conditions. IPO-mania (and the tolerance of poor companies) comes and goes, as does the love affair with small caps. Indeed, once most investors figure out they’ve not been duly rewarded for the extra risk they’ve taken on by owning the iShares Russell 2000 Index ETF since 2009, they’ll lose interest and shed the fund; they may even shed individual small-cap stocks, growing tired of their tepid performance. Ironically, once that happens, the potential “edge” in owning small caps will seep back into that segment of the market.

The bad news is that we aren’t there yet, making IWM a tad pointless compared to a large-cap fund. We’ll likely need a big fat capitulation for the small-cap as well as the large-cap market to get there … and to do that, we’ll likely need a bear market.

Though there are certainly some attractive individual small cap stocks out there, buying them pre-packaged in an index fund doesn’t really do you a lot of good right now.

As of this writing, James Brumley did not own a position in any of the aforementioned securities.